A Question of Value

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All too often since the 1980s gave birth to America's historic "merger mania," the story has been the same. The initial champagne celebration gives way to a major hangover once the final cost of the deal is tallied. In fact, taken as a whole, mergers and acquisitions in recent years have produced a disheartening negative 12 percent return on investment.

It may come as a surprise, then, that among the clearest areas of progress during the past two decades has been company valuation — the art of figuring how much a target is worth, so that the offering price can include the smallest premium necessary to win the prize.

"We know much more about a target company today that we ever did 20 years ago," says David Harding, a senior partner with Bain & Co. and co-author of Mastering the Merger (Harvard Business School Publishing, 2004). "It's the difference between examining a patient with a stethoscope or with a CAT scan."

Indeed, acquirers have found the financial data to create good models ever more readily available, resulting in the increased reliability of discounted cash flow (DCF) estimates, and leading to the refinement of all kinds of valuation techniques. On top of that, companies have adopted far more rigorous due-diligence practices, drawing many of them from the entrepreneurial private-equity sector.

Subtracting the Multiple

While many factors have contributed to the improvement in valuation techniques, perhaps the most important of them flow from new technologies — often summoned through the magic of the Internet. Consider how complicated and time-consuming it was in 1985 merely to obtain all the needed public financial statements.

"We used to have to send guys from our D.C. office [over] to the [Securities and Exchange Commission] to copy 10-Ks for a nickel a page — and even then you often couldn't get all the filings," recalls Robert Reilly, managing director of Chicago-based valuation consultancy Willamette Management Associates. Now public filings are available online. In addition, such operations as FactSet Mergerstat LLC and Ibbotson Associates provide a constant flow of M&A transaction data and cost-of-capital statistics.

When the numbers are right, that can make the task of calculating the right discount rate a relative breeze. "You can now get every input you want for the capital asset pricing model [CAPM] for every industry and every time frame," says Reilly, referring to the model commonly used to determine the risk-adjusted cost of equity. "Our ability to be more precise in the application of CAPM has improved a lot in the past 20 years."

Adding to the improvement have been advanced cost-of-capital methodologies, notes Jay B. Abrams, president and CEO of North Hollywood, California-based Abrams Valuation Group Inc. For instance, analysts can now adjust discount models for special cases, such as nonpublic companies and smaller targets. "Large firms are more stable and small firms more volatile," says Abrams. "So for smaller firms, you should be using much higher discount rates" than the CAPM would yield. Newer methods, such as the Fama-French three-factor model, do a better job of capturing such subtleties.

The improvement in DCF calculations has ushered out, in many cases, the once-dominant role of such less-exact methods as historic market multiples. And for many finance executives, it's been good riddance.

"It used to be that market multiples were all anybody looked at," says Robert Holthausen, an accounting and finance professor at the University of Pennsylvania's Wharton School, "in part because discounted cash flows were so hard to do."

Not that multiples have lost their clout entirely; the calculations remain a standard tool — particularly for private-equity firms — because they offer a helpful means of comparing what others have paid in similar transactions. And they are still the main way of pricing deals in the technology sector. Rocky Pimentel, executive vice president and CFO of San Mateo, California-based game software maker Sorrent Inc., and a veteran of many high-tech mergers, says that most of the deals he has worked on, including Microsoft Corp.'s acquisition of WebTV, were largely based on multiples. "When you are in a high-growth industry, you are usually more willing to pay more for future revenue growth, and are less focused on the cost structure," he says.

Among the companies that came to rely more on discounted cash flows and cost of capital was New York-based Colgate-Palmolive Co. By the late 1980s, the company's management had gone through a period of diversification, and had decided to focus the business and to increase efficiencies. That meant adopting a formal approach to investments globally — from capital spending to acquisitions — based on DCF and cost of capital.

"We had used other approaches over the years, like sales growth and profitability trends," says now-retired Colgate CFO Robert Agate, who headed finance for the consumer-products giant from 1987 to 1996. "But when looking at high- and low-inflation countries or different types of businesses, it was apparent that we needed a method that would provide a dollar-based common denominator for viewing the various transactions." The approach also called for management to determine the likely upside and downside of its projections, which has the virtue of encouraging a focus on business assumptions rather than on methodology.

Colgate's DCF approach proved valuable in such deals as the company's January 1995 acquisition of the Brazilian firm Kolynos. The economic environment was uncertain — the Mexican peso had undergone its steep devaluation just a month earlier (Kolynos had operations in Mexico) — and Brazil was coping with its own high-inflation environment. The valuation methodology enabled Colgate to compare this investment with others it might make elsewhere.

Now a corporate director serving on the board at Allied Waste Industries Inc., Agate has seen yet another new factor improving the depth and breadth of an acquirer's information: board activism. Inspired in part by the post-Enron focus on governance and the threat of shareholder lawsuits, board members have been pushing corporate managers to make a stronger case for the deals they propose. "For me, acquisition justification must cover at least strategic consistency; the financial plan, including scenarios for growth; and synergies, discounted cash flow expectations, and general risk issues," says Agate.

More-thorough due-diligence efforts also give acquirers better insight into the costs and revenues of target companies — and, of increasing importance, also their accounting practices. "Buyers are really doing much deeper accounting diligence now," says Glenn Gurtcheff, managing director and co-head of middle-market M&A for Piper Jaffray & Co. in Minneapolis. "They're not just taking the company's audited and unaudited financial statements at face value; they are really diving into the numbers and trying to understand not just their accuracy, but what they mean in terms of trends."

The Overpayment Quandary

Better DCF forecasts have another benefit: the ability to increase the complexity of M&A financing.

The past decade saw a rise in mezzanine financing, contingent convertible bonds, and interest-only notes, among many other structures — products that in some cases provide acquirers with cheaper and more flexible sources of capital.

Willamette's Reilly argues that such financing has become possible largely because better valuations have helped lenders see that deal pricing is less risky. "If you have done a rigorous analysis, are certain about the discount rate, and really know what the expected cash flow is going to be over the next 10 or 20 years, then you can convince the lender and the equity holder to buy these securities at a reasonable price," he says. "On the other hand, in the 1980s you might have priced the deal simply on multiples. The lenders would have said, 'I'm not really confident about what the future will bring, so I'm not willing to purchase that kind of security.'"

He cites the recent example of a $3.7 billion acquisition of power-generation company Texas Genco Holdings by a consortium of private-equity companies. The highly leveraged purchase included several layers of debt financing, made possible because the consortium was able to persuade lenders that its cash-flow forecasts were accurate. As part of the deal, buyers had arranged to sell some of the company's future electricity to investors as a commodity hedge.

If valuation has improved so much, why do analyses show that companies so often overpay? One obvious reason: the inexactitude that can creep into pricing when synergies are calculated poorly (see "Fool's Gold," New Deals, February). And then there's the role of the imperial CEO.

Thomas Lys, an M&A professor at Northwestern University's Kellogg School of Management, says the improvement in valuation techniques can be negated when M&A deteriorates into a game of tweaking the numbers to justify a deal the CEO wants to do regardless of price. "Valuation is just an excuse," he says. "The moment it becomes clear that the CEO wants to do the deal no matter what, his investment banker and advisers are best advised to tell the emperor that his clothes are beautiful." In other words, value is one thing — price can be quite another.